It's one of the great underreported stories of our time: the rate at which the world's population is growing has actually slowed by more than 40% since the late 1960s. What's more, the number of people in the world could actually start to decline over the next 60 years, according to the United Nations Population Division. Under this scenario, the world's population, now 6.8 billion, may peak at 9 billion by 2070 and then start to diminish. Long before then, some nations' populations will already be shrinking, as the world's fertility rate falls below replacement levels, which is 2.1 children per family. We consider these population trends a social change with potentially profound repercussions for the global economy. These trends are important because, as has often been observed, demographics is destiny. We think that demographics especially influences destiny in this way: when a nation has more working-age adults than it has elderly adults, its economy tends to grow at above-average rates. Conversely, when a nation has a large number of seniors relative to working-age people, its economy tends to be constrained. So, contrary to popular stereotypes, the world's biggest demographic problem over the next 40 years is unlikely to be overpopulation, but the opposite: a decreasing (and aging) population, which presents complicated and subtle quandaries of its own. And as the world ages, the economic prospects are likely to be brightest for those nations aging the most slowly. Age Distribution Matters In studies such as Economic Growth and Demographic Transition, published by the National Bureau of Economic Research, it's been shown that the way the population of a nation is distributed across different age groups can have a great impact on that nation's economic performance. For instance, nations with a high proportion of children are likely to devote a high proportion of public and private money to their care, which may gladden the hearts of parents but tends to depress the pace of economic growth. In contrast, if most of a nation's population is of working age, productivity tends to rise, producing what's called a "demographic dividend" of economic growth. If favorable public policies are in place to promote business competitiveness, an ample working-age population can create virtuous circles of wealth for a nation. However, if a large proportion of a nation's population consists of seniors, the effect can be similar to that of a nation with lots of children: a large share of public and private resources are allocated to a relatively less productive segment of the population, which in turn tends to dampen economic growth. For nations, population growth per se is not as important to economic growth as the ratio of workers to seniors. In fact, in China and India a declining rate of population growth has contributed to their own much-chronicled economic success story of the past 15 years. What helped both China and India was the multitude of workers relative to the number of seniors. When the fertility rate of China and India fell, legions of people born previously were working, [...]

Behaviorally Modified Asset Allocations for Passive Preservers

In the last two articles, we learned several important concepts as it relates to creating behaviorally modified asset allocations, or BMAA (also referred to as best practical allocation). We learned that in order to develop proper guidelines for applying biases to asset allocation decisions, advisors must answer a central question: when should I, as the advisor, attempt to change the way my client is behaving (i.e., regulate the effects of behavioral biases) to match an asset allocation I believe is correct for them, and when should I adapt the asset allocation recommendation to match the client's behavioral profile? To answer that question, we learned two guidelines. Guideline one said that the decision to regulate or adapt to a client's behavioral biases during the asset allocation process depends in large part on the client's wealth level. Specifically, the wealthier the client, the more the advisor is safely able to adapt the asset allocation to the client's behavioral biases. The less wealthy, the more the advisor should attempt to regulate a client's biased behavior to match a rational asset allocation. Guideline two said that the decision whether to regulate or adapt to a client's behavioral biases during the asset allocation process also depends fundamentally on the type of behavioral bias being exhibited by the client. Specifically, clients exhibiting cognitive biases, which stem from illogical reasoning, can be regulated, while those clients exhibiting emotional biases, which stem from impulsive feelings, should be adapted to.

We will now put these ideas into concrete action by examining each behavioral investor type and how one might think about creating a BMAA for each one. We will begin with the Passive Preserver (PP). Our process will be to review the basics of each BIT (today will be the PP), discuss the primary biases at work and how we incorporate these biases into our allocation recommendation, and then discuss how to modify an asset allocation based on these biases. Note that in this exercise we will not be examining standard of living risk. We will tie that concept in later in subsequent articles.

Review of Passive PreserversPPs place a great deal of emphasis on financial security and preserving wealth rather than taking risk to grow wealth. Some PPs obsess over short term performance and are slow to make investment decisions because they aren't entirely comfortable with change - which is consistent with the way they have approached their professional lives - being careful not to take excessive risks. Many PPs are focused on taking care of their family members and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, PP biases tend to be emotional rather than cognitive. As age and wealth level increase, this BIT becomes more common. Behavioral biases of PPs tend to be security-oriented biases such as endowment bias, loss aversion, status quo and regret. PPs also often exhibit cognitive biases such as anchoring and mental accounting.

ScenarioSuppose you are beginning an engagement with a new client, Stan. You give him a standard of risk tolerance quiz and determine that he is a conservative investor. After that, you give him a test for behavioral biases of conservative clients. Based on the answers to the bias questions you determine that Stan is a PP. Some of your other clients are conservative but they are not biased like Stan. The object of this exercise is to see how to create a BMAA for a PP versus a non- or mildly-biased conservative investor. Generally, this can mean that a PP should accept less risk in his portfolio than those clients without bias. Since Stan is a passive preserver, he is not predisposed to taking on additional risk to his portfolio anyway. This makes working with PP an easier task than with some other BITs.

The following analysis presents two investment programs, one for Steve (a non-biased conservative investor) and one for Stan (a PP). You are using Steve's portfolio allocation as a baseline for creating Stan's. Your basic task as to assess a retirement goal for Stan and the associated risk associated with the return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.